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Issue Overview

Over the past couple of years, the public perception of the banking industry has dramatically worsened. This deterioration is mostly fuelled by increasing scepticism on the quantity and quality of actions taken as a reaction to the financial crisis. The uncertain economic recovery, ongoing fiscal crises and continuous credit challenges have greatly influenced the public to believe that some of the most critical issues highlighted by the crisis have not been addressed, specifically the level of systemic risk, banks’ governance, bankers’ compensation and how to deal with problem assets. All of this has contributed to a significant erosion of public trust in the overall financial services industry, including industry players and regulators, and has ultimately created a broad lack of confidence and uncertainty. The industry, regulators and supervisors are part of the same system and a lack of trust in one of these areas has a negative impact on the overall system. In addition, there is widespread fear that current financial system governance is not sufficiently adequate to deal with the potential turbulence that may arise, thereby causing further instability.

Council Focus

An overarching objective of the Global Agenda Council on Banking & Capital Markets is to focus on sustainable growth while reducing volatility in financial markets. Many topics in banking and capital markets require the attention of the industry, regulators and supervisors. Some of these issues, which are highly relevant in achieving the Council’s broader objectives, include:

  • restoring public trust and confidence in the industry, regulators and supervisors
  • redesigning industry regulations
  • developing capital markets in emerging economies.

The Council looks to outline recommendations on these topics, as well as highlight other economic challenges that will contribute to how the industry develops going forward.

Restoring Public Trust and Confidence in the Industry, Regulators and Supervisors

The Council believes that it is vital to restore trust and confidence in the industry as well as in regulatory and supervisory bodies. Trust is the ultimate foundation of the industry as no capital ratio below 100% is inherently safe in all circumstances. While an economic recovery is essential to help restore the public’s perception of the financial system, the industry can facilitate the reparative process in a number of ways. The Council focuses on a few areas and provides the following recommendations:

Understand the shortcomings of the established economic model and its implications on banking and capital markets

Although many have criticized the current free market capitalism model, the Council believes that it is not clear whether the model has failed or is inherently flawed. It is, however, profoundly obvious that the model has been abused by both financial markets and governments. And, notwithstanding all the commentary, no other viable alternative models have emerged or proven to be more successful. Nevertheless, the current model certainly has considerable shortcomings. Therefore, the Council recommends that the industry, regulators and supervisors understand what is good and what may be improved in the current model to avoid similar crises in the future. This is also important to help emerging economies shape their own model, as they try to adapt it to local needs.

Recognize the role and responsibilities of government policies in generating systemic risk

While access to credit/finance is a crucial component of economic growth, loose lending practices may create systemic risk. The role of government policies must be objectively analysed, with particular reference to the sub-prime crisis. Questions requiring answers include: “How much do government policies shape banks behaviour?” and “How much do these policies contribute to the emergence of credit bubbles?” Therefore, any policies that encourage the widespread availability of credit should be discussed by the industry and policy-makers to identify, manage and mitigate any emerging systemic risks.

(Re)define the scope and role of the industry: improving the model

The banking and capital markets sectors need to rediscover their traditional role as the growth engine of economies. Banks and capital markets should emphasize their traditional core roles of intermediating capital, providing liquidity and allocating risk for the economy. Council Members believe the industry and regulators should first identify the scope of activities that the banking (defined as all institutions which implicitly or explicitly have their deposits guaranteed by the government) and capital markets sectors should perform and then ask how best to regulate them in order to enable and support these functions. It is critical to avoid regulatory arbitrage and “black holes”. The issue of international regulatory harmonization was among the key themes discussed within the Council on Systemic Financial Resilience. It is also high on the Financial Stability Board’s agenda, which was represented in the discussions by Mark Carney, a Member of the Council on Systemic Financial Resilience.

Improve the financial system’s “engagement strategy” and social contribution

For a long time, the industry has emphasized shareholder value, paying little attention to other stakeholders’ interests. Now, however, seems an appropriate time to rebalance this relationship. Although shareholders will always have a central position, other stakeholders, such as regulators, customers and society at large, despite playing different roles, have a meaningful function that is not always recognized or served. The Council believes that creating sustainable shareholder value is very difficult to achieve without actively reflecting stakeholders’ interests. Therefore, the Council recommends that the industry recognize the importance of all stakeholders and seek to identify ways in which to actively reflect their interests in the institutional strategy. In addition, the Council thinks that, in the current environment, the confidence level and the image of the banking and capital markets industry would greatly benefit from a more “engaged strategy”. However, this must be driven by a genuine interest in the issues that matter to customers (and society at large).

Redesigning Industry Regulations

The Council believes that, in addition to restoring trust and confidence, some fundamental issues related to the regulatory framework need to be redesigned with a clear set of principles, in parallel to the recommendations mentioned above. This could be achieved by instigating the following:

Shift from rule-based to principle-based regulations

An active debate continues on whether rule-based or principle-based regulations are more effective. The former consists of detailed rules prescribing how outcomes must be achieved, while the latter focuses solely on outcomes, irrespective of how they are delivered. The Council acknowledges that certain countries, such as the United Kingdom, have not had great success with principle-based regulations. Nevertheless, the Council still maintains that the industry should shift from a rule-based approach to principle-based regulations, guided by the overarching principle of “the need for an efficient and effective finance system to address society’s needs.” Adopting a principle-based approach to regulations would ensure that individuals and institutions have to deliver proof of adhering to the principle, rather than try to “work around” the imposed rules. Rule-based regulation has led to the creation of non-bank banks (shadow banking) to fill the holes created by tightening rules for banks. It has also led to significant decreases in bank lending due to the need to comply with the various rules. At the same time, a principle-based approach facilitates the pragmatic application of the principles as deemed fit. In addition, a principle-based regulatory approach would be applicable to different jurisdictions, which would support the Financial Stability Board’s work on coordinating the work of G20 national financial authorities and international standard-setting bodies. Some further guidance on how to achieve this international coordination can be found in the Council on Systemic Financial Resilience’s report. For a principle-based approach to be successful, however, it must have:

  • a supervisor with sufficient enforcement authority and strong governance
  • global coordination and collaboration with other financial sector supervisors through a Memorandum of Understanding and with the government to ensure global stability and that the principles’ objectives are met.

Principles to keep in mind include:

  • the true diversification of risk and profit
  • defined red flags
  • aligned incentives (e.g. deferred bonus payouts)
  • a contained ratio of banking sector to total GDP
  • a contained level of credit/leverage in sub-sectors of the economy or specific asset classes.

While a number of regulatory proposals are already well under way, many regulations have yet to be specified. The Council believes that discussions on regulation would benefit from a shift from “more vs less” to “principle- vs rule-based” and from “complex and prescriptive” to “simple and effective”. The financial systems of Canada, Australia and Brazil have faced the global crisis in a fairly successful way as a result of principle-based regulation.

“Make regulation and supervision work better” / Avoid regulatory fragmentation

It is critical for the financial services industry, as it is for any industry, to have a level regulatory playing field. Indeed, a fragmented regulatory environment has a negative impact on competition and creates more challenges globally. As such, the Council endorses the Financial Stability Board’s mandate to coordinate the work of G20 national financial authorities and international standard-setting bodies. To achieve this goal, regulators and supervisors need to work together both at the national and international levels. The governance and consultation process on new regulation is also important as better coordination of different rules, such as Solvency II, Basel III and International Financial Reporting Standards (IFRS), is needed. Peer review is also essential, which could be undertaken under the International Organization of Securities Commissions (IOSCO) principles for the capital markets regulator. The sharing of information between regulators and mutual assistance within the financial sector are also critical to the reduction of regulatory arbitrage. In addition, the Council thinks that a political effort is needed to avoid a regulatory “black hole” and regulations arbitrage. The G20 could be the right framework for political systems to play a role, while simultaneously reducing the risk of nationalism.

Deepen the regulatory talent pool and expertise

Historically, regulators have not been able to attract talented, motivated and experienced professionals; the job did not pay well and was often perceived as a default option for those who did not succeed in the financial industry. Regulatory bodies should be able to attract talent with the appropriate skill level necessary to monitor the industry with authority and credibility. The Council recommends more focus on providing training for regulators, offering competitive compensation and further validating the importance of the job.

Developing Capital Markets in Emerging Economies

Many emerging economies find themselves subject to large capital flows, yet they often lack domestic capital markets (particularly debt capital markets) that are large enough to channel those flows. Underdeveloped capital markets in emerging economies create several issues:

  • economies that are largely dependent on the banking industry are more negatively impacted by banking system volatility
  • small and medium-sized enterprises (SME), often key job creators and the backbone of many emerging economies, have little funding alternatives
  • an absence of capital markets in their local currency requires emerging economies to take on additional currency exposures, which poses an additional constraint to SME funding.

The existing capital markets model of western nations still applies to emerging economies, although the local environment and some of the regulatory pitfalls highlighted by the crisis need to be taken into consideration. Brazil is an example of a country that has successfully developed its equity capital market. Although creating the correct governance structures (e.g. regulator, protection rules for minority investors, etc.) has taken some time, the key challenge has been to create confidence in the market. Overall, the process has taken roughly 10 years.

Therefore, while the Council believes that governance principles are a very important part of financial markets, it is difficult to postulate a certain style of governance and apply it in all localities. The Council recommends a study to understand the historical development of successful capital markets. This might facilitate the creation of a framework that is useful to new markets while, at the same time, underscoring the notion that transparency is crucial in all markets.

Challenges associated with the development of capital markets in emerging economies that should be taken into account when thinking about adopting the western capital market model include:

  • Size and scale: the largest obstacle in the development of capital markets is reaching a certain size and scale to make them successful. Many believe that it is impossible for each individual country to achieve this on its own. Therefore, a potentially more realistic approach could be to reach scale by stimulating regional consolidation. A prerequisite for this would include some loss of sovereignty to integrate capital markets. Although this may be realistic for some regions (e.g. East Africa), it is much less so for others, at least in the short term (e.g. Latin America).
  • History and fear of inflation: a big challenge in developing debt capital markets in many emerging economies is the legacy issue of inflation. While in theory the demand for long-term investment products exists, investors shy away from them because there is a concern that inflation will erode investment return. In Brazil, for example, long-term funding at acceptable rates in local currency is only provided by the Brazilian Development Bank (BNDES). This forces firms to borrow in the international market.
  • The transition from an export-led to a domestically-driven growth model: the transition may be facilitated by building a pool of institutional, long-term investors to satisfy the need, across the emerging world, of financing for infrastructure development. Since the global financial crisis, long-term institutional investors have been implementing short-term investment objectives.
  • The gap between debt requests and the accumulation of financial wealth by households.

Facing Other Economic Challenges

The Council discussed other challenges related to banking and capital markets that are emerging and will play an important role in the global economy in 2012.

The impact of the low-interest rate environment

The search for yield in this prolonged low-interest rate environment will cause different allocations of capital, which could inflate bubbles that ultimately may destabilize the economic system and impede sustainable economic recovery. Low interest rates and volatile growth will also affect the banking and capital markets industry and change the roles and responsibilities of the financial system’s various players. On a larger scale, they impact the ability of both the public and private sectors to meet society’s future liabilities in areas such as pensions and healthcare. To this end, a new Global Agenda Council on Social Security Systems is being formed to address some of the key challenges and identify possible solutions.

The view on the profitability of banks is shifting as the banking model and its ability to lend credit are being impacted by changes in the growth environment. Two opposing forces seem to be at play that will have quite an impact on the global economy. One is the regulatory and political pressure on the financial industry to deleverage; the other is the need to expand credit and sustain a weak economy. To address the latter, in the past stimulus packages typically were created. However in many developed economies, public balance sheets are now severely stressed and governments are therefore actively encouraging banks to lend. While understandable, it is not clear whether this approach is sustainable either. According to many analysts, overall leverage in the economy must be reduced rather than merely shifted between sectors, and policy-driven lending might increase the entanglement between sovereign balance sheets and the banking system, leading to moral hazard further down the line.

Two questions invariably arise:

  • How do the stakeholders intend to deploy the balance sheets of the different sectors (public, financial, etc.)?
  • How can banks meet different stakeholders’ expectations (i.e. shareholders asking for returns, regulators asking for deleveraging, clients asking for credit)?

Capital markets are experiencing a movement towards “short-termism” and speculation. Therefore, they are moving away from their original purpose of asset allocation and risk management. Long-term investors are increasingly investing in capital markets with a short-term objective due to the low-interest rate environment and the uncertainty of the global market. This poses a challenge to the G20 policy objective of more domestically-led growth.

Linkages between the financial system and sovereign debt

The management of sovereign debt and trade balances has serious implications for the financial system – both in terms of risk management and, indirectly, in terms of instability. This issue is currently very pertinent in the Eurozone, although it is also relevant in other regions, and it continues to drive both global imbalances and, by extension, potential risks to the financial system. With sovereign debt levels projected to rise, the issue will remain highly relevant over the next few years. Prudent balance sheet management will apply to both the public sector and the banking sector.

Next Steps

Council Members will disseminate the Council’s recommendations as they feel appropriate to move them forward. In addition, the Council will provide input into the Council on Systemic Financial Resilience’s recommendations to the Financial Stability Board.


The opinions expressed here are those of the individual members of the Council and not of the World Economic Forum or any institutions to which they are affiliated.